The Many Flavors of Crowdfunding

Emilie Holmes is not a name you are probably familiar with. She’s the owner and operator of a custom-made tea bar, Good and Proper Tea, which operates out of her van in London. But to start her tea business, a passion she harbored, she needed financing. The Guardian details how, when traditional methods only provided her with two thirds of the capital necessary to get started, Emilie turned to Kickstarter, the popular crowdfunding platform for creative business projects and individuals. Within a month, Emilie had successfully crowdfunded the rest of the capital necessary to turn her 1974 Citroen van into a functioning tea truck. Now, able to share her love of unique and flavorful teas with communities throughout the UK, Emilie has a steadily growing business.

More and more, entrepreneurs with inspiring business ideas or nascent companies are turning to alternative funding sources to supplement bank financing, or even replace it. Crowdfunding, a relatively new phenomenon, has filled a void in the entrepreneurial finance arena, providing resources for smaller funding efforts and less traditional businesses. While bank financing remains the dominant route for capital expansions of new business (usually through debt financing), there appears to be space for crowdfunding to support some of the especially innovative, risky, or novel businesses of entrepreneurs.

The Challenges of Traditional Funding Sources

Firms looking to banks for credit have found it harder than before the Great Recession. The following chart shows the percentage of firms who couldn’t secure bank financing or chose not to out of fear of denial. The data comes from the Kauffman Firm Survey, an 8 year poll of a representative sample of startups in the U.S.

% always denied new bank credit

% did not apply for credit because they feared denial

2008

14.9

17.6

2009

22.9

21.3

2010

23.3

19.2

2011

19.4

18.1

 

In light of the difficulties that entrepreneurs face in traditional financing markets, crowdfunding can serve as a useful avenue to fill that funding void.

 

The Current State of Crowdfunding

There are three main types of crowdfunding, and the type of business or project an entrepreneur takes on will determine how useful crowdfunding will be and what type of crowdfunding matches with the goals of that company.

Reward crowdfunding is the most popular type of crowdfunding, and was the type used by Emilie. Kickstarter is the most popular of these reward crowdfunding platforms. In exchange for contributions to support the project, creators (as they are called on Kickstarter) promise rewards to backers. These rewards vary in size based on the amount contributed to the project. Often, creators will reward backers with prototype or custom versions of the product before they are up for sale. One advantage of reward based crowdfunding is the dual impact of fundraising and marketing. Along with finding a source of funding, rewards can excite future customers that can then advertise the product to other potential customers.

Debt crowdfunding is another style of crowdfunding businesses are taking advantage of. Lending Club and Zopa are two of a growing sector of debt crowdfunding companies, both in the United States and in Europe. For this post, I am considering debt crowdfunding and peer-to-peer lending the same, although there is some disagreement on this topic. Debt based crowdfunding is simply a loan funded by a group of many small investors to an individual. Investors choose to provide funding for specific loans based on their risk and return, either independently, within investment groups, or algorithmically. Then a matching platform initiates the loan process. The platform will solicit and approve borrowers on a number of different factors. Borrowers are still rated partially on their creditworthiness, as they would be for a normal bank loan, but interest rates are often lower than the typical bank loan. Once the borrowers are approved, graded, and the terms of the loan are set, the platform selects investors who have chosen to invest in this type of loan. As the borrower repays the loan, investors receive monthly interest payments.

Small, individual, investors aren’t the only ones involved in this market. Venture capitalists and angel investors are also paying attention and funding businesses that come to these peer-to-peer lending platforms. Of the nearly $900 million invested by venture capitalists and angels through crowdfunding sites, about 80 percent of that sum went to debt crowdfunding platforms.

Equity crowdfunding is the third main form of crowdfunding. One of the most popular platforms for equity crowdfunding is AngelList. Contrary to other types of crowdfunding, equity crowdfunding gives investors a stake in the ownership of the companies they invested in, as opposed to rewards or interest payments. Although this type of investment was previously limited to the accredited investor – an individual with net worth of at least $1 million or a yearly income of over $200,000 (add definition of accredited investors) -- the 2012 Jumpstart Our Business Startups (JOBS) Act, granted unaccredited investors the ability to take part in equity financing.

As part of the JOBS Act, the Securities and Exchange Commission (SEC) has been tasked with designing the guidelines that regulate equity crowdfunding at the federal level. The SEC, concerned with the fraud potential that crowdfunding brings, has been hesitant to produce explicit rules. Two years after the passage of the bill, the rules remain unwritten. To help bridge this gap between businesses that need funding and funders looking to invest, states have passed their own legislation that allows intrastate equity crowdfunding. This allows state residents to crowdfund businesses located within the state. Equity crowdfunding can open new investment markets to individuals who otherwise would have a less productive use for excess capital.

Challenges of Crowdfunding

While the wild success stories of Pebble and GoldieBlox allow entrepreneurs to dream, crowdfunding does carry some significant risks and concerns. With equity crowdfunding, experienced investors worry that both borrowers and lenders expose themselves to significant risk.

For borrowers, choosing to engage in the crowdfunding market for equity bypasses some of the more experienced investors, who can provide valuable mentoring as equity investors. Also, some venture capitalists and angel investors have expressed hesitancy in investing in a venture that had previously acquired capital through equity crowdfunding, preferring not to engage with a large number of inexperienced investors.

For lenders, the investment community is concerned with fraudulent fund-seekers taking advantage of naïve investors, who underestimate the level of risk they are undertaking. The primary strategy to minimize this type of risk is a proactive and engaged investment platform that effectively blocks out fraudulent borrowers. Experienced investors also advocate for a co-investment strategy, where either crowdfunders or experienced investors invest only after the other has reached some threshold, to mitigate risk. When platforms are able to promote a community of engaged investors, with an environment of open data, and facilitate safe and easy communication, a functioning investment market can emerge.

These and other crowdfunding avenues, such as charity crowdfunding, are new ways to engage marginal investors and entrepreneurs seeking investment or funding opportunities. A new business owner can face down the uncertainty of bank financing and motivate a separate group of investors to fund some or all of their venture. And the crowd, as a new source of investors, can fill a funding void in mismatched capital markets where nascent or growing firms struggle. As a complement (or in rare cases, a substitute) to traditional financing, crowdfunding has the power to enable more business startups and ease the effects of a constrained financial market.

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chris jackson

Chris Jackson

Chris Jackson is a research assistant in Research and Policy for the Ewing Marion Kauffman Foundation, assisting in the understanding of what policies and environments best promote entrepreneurship and education in the pursuit of economic growth.